This chapter illustrates hedging policies and interest rate gap management. Since banks keep interest rate gaps open, they need to define limits to such gaps. Limits are derived from setting a cap to downside risk, with risk being measured as the adverse deviation of the N11, used as target variable. Limit setting is discussed in Section 24.1.

Hedging programs use derivatives to make gap comply with limits across periods. Section 24.2 provides two examples of hedging solutions, one over a single period, and another when the horizon extends over multiple periods.

When considering hedging, entire changes of the term structure of interest rates have to be considered, notably given that bank's structural position is borrowing on the short end and lending on the long end. The gap model can accommodate changes of the steepness of the term structure as well as other transformations, as long as interest rate references used for gap models are spread along the curve. Section 24.3 provides a case study for illustrating hedging opportunities when the entire curve and its steepness changes through time. This section does not deal yet with simulations of the term structure, which are deferred to Chapter 37.

Finally, it is possible to account for uncertainty with respect to the future volume of assets and liabilities, or address business risk, jointly with interest rate risk, by using multiple scenarios and finding an optimum hedge. Section 24.4 provides a methodology for addressing the two risks jointly by cross-tabulating discrete numbers of business scenarios with interest rate scenarios, and finding the best hedges, defined as those which maximize expected N11 at a given risk level.

MANAGING GAPS: SETTING UP LIMITS

Banks often keep interest rate gaps open, notably when they have mismatch risk for capturing the positive spread between long-term interest rates and short-term interest rates (the "structural position"). In such a case, the variable rate gap would be negative on short-term rates and positive for long-term interest rates (those which are considered fixed over a long period). Open positions implies the usage of limits for capping the risk borne by the bank.

Gap limits have the effect of capping the variations of the net interest income. Limits are set by the ALCO. Either they follow some basic rules or they use some earning-at-risk modeling of the Nil for setting limits. In both cases, the management would set up a limit, whose purpose is to set a maximum downside move of the NIL

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